Financial

Statement
Analysis
 
 
K.R. Subramanyam

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 11-2

Equity Analysis and Valuation

11
CHAPTER
 11-3

Earnings Persistence
• Earnings persistence is a key to effective equity
analysis and valuation
• Analyzing earnings persistence is a main
analysis objective
• Attributes of earnings persistence include:
– Stability
– Predictability
– Variability
– Trend
– Earnings management
– Accounting methods Analyze
 11-4

Earnings Persistence

Recasting and Adjusting

• Two common methods to help assess earnings
persistence:
– Recasting of income statement
– Adjusting of income statement
• Recasting and adjusting earnings
aids in determining the earning power.
 11-5

Earnings Persistence
Recasting and Adjusting
• Information for Recasting and Adjusting
– Income statement, including its subdivisions:
• Income from continuing operations
• Income from discontinued operations
• Extraordinary gains and losses
• Cumulative effect of changes in accounting principles
– Other financial statements and notes
– Management’s Discussion and Analysis
– Others: product-mix changes, technological innovations, work
stoppages, and raw material constraints
 11-6

Earnings Persistence
Recasting Earnings and Earnings Components
• Aims at rearranging earnings components to provide a
meaningful classification and relevant format for analysis.
– Components can be rearranged, subdivided, or tax effected, but
the total must reconcile to net income of each period.
– Discretionary expenses, components like equity in income (loss)
of unconsolidated subsidiaries or affiliates should be segregated.
– Components reported pretax must be removed along with their
tax effects if reclassified apart from income from continuing
operations.
 11-7

Earnings Persistence
Recasting Earnings and Earnings Components
– Income tax disclosures enable one to separate factors
that either reduce or increase taxes such as:
• Deductions—tax credits, capital gains rates, tax-free income,
lower foreign tax rates
• Additions—additional foreign taxes, nontax-deductible
expenses, and state and local taxes (net of federal tax
benefit)
– Immaterial items can be considered in a lump sum
labeled other.
 11-8

Earnings Persistence
Recasting Earnings and Earnings Components
Campbell Soup Company
Recast Income Statements ($ mil.)
Item Year 11 Year 10 Year 9 Year 8 Year 7 Year 6
13 Net sales $ 6,204.1 $ 6,205.8 $ 5,672.1 $ 4,868.9 $ 4,490.4 $ 4,286.8
19 Interest income 26.0 17.6 38.3 33.2 29.5 27.4
Total revenue $ 6,230.1 $ 6,223.4 $ 5,710.4 $ 4,902.1 $ 4,519.9 $ 4,314.2
Costs and expenses:
Cost of products sold (see Note 1 below) $ 3,727.1 $ 3,893.5 $ 3,651.8 $ 3,077.8 $ 2,897.8 $ 2,820.5
Marketing and selling expenses (see Note 2 below) 760.8 760.1 605.9 514.2 422.7 363.0
145 Advertising (see Note 2 below) 195.4 220.4 212.9 219.1 203.5 181.4
144 Repairs and maintenance (see Note 1 below) 173.9 180.6 173.9 155.6 148.8 144.0
16 Administrative expenses 306.7 290.7 252.1 232.6 213.9 195.9
17 Research and development expenses 56.3 53.7 47.7 46.9 44.8 42.2
102 Stock pricerelated incentive programs (see Note 3 below)
15.4 (0.1) 17.4 (2.7) — 8.5
20 Foreign exchange adjustment 0.8 3.3 19.3 16.6 4.8 0.7
104 Other, net (see Note 3 below) (3.3) (2.0) (1.4) (4.7) (0.4) (9.0)
162A Depreciation (see Note 1 below) 194.5 184.1 175.9 162.0 139.0 120.8
103 Amortization of intangible and other assets (see Note 3 below)
14.1 16.8 16.4 8.9 5.6 6.0
18 Interest expense 116.2 111.6 94.1 53.9 51.7 56.0
Total costs and expenses $ 5,557.9 $ 5,712.7 $ 5,266.0 $ 4,480.2 $ 4,132.2 $ 3,930.0
23 Earnings before equity in earnings of affiliates & min. interests
$ 672.2 $ 510.7 $ 444.4 $ 421.9 $ 387.7 $ 384.2
24 Equity in earnings of affiliates 2.4 13.5 10.4 6.3 15.1 4.3
25 Minority interests (7.2) (5.7) (5.3) (6.3) (4.7) (3.9)
26 Income before taxes $ 667.4 $ 518.5 $ 449.5 $ 421.9 $ 398.1 $ 384.6
Income taxes at statutory rate* (226.9) (176.3) (152.8) (143.5) (179.1) (176.9)
Income from continuing operations $ 440.5 $ 342.2 $ 296.7 $ 278.4 $ 219.0 $ 207.7
135 State taxes (net of federal tax benefit) (20.0) (6.6) (3.8) (11.8) (8.6) (8.0)
Investment tax credit — — — — 4.4 11.6
137 Nondeductible amortization of intangibles (4.0) (1.6) (1.2) (2.6) (1.4) —
138 Foreign earnings not taxed or taxed at other than statutory rate
2.0 (2.2) (0.2) 3.2 11.1 15.2
139 Other: Tax effects (17.0) (2.2) (0.1) (3.7) 7.5 (4.7)
Alaska Native Corporation transaction — — — — 4.5 —
22 Divestitures, restructuring and unusual charges — (339.1) (343.0) (40.6) — —
Tax effect of divest., restructuring & unusual charges (Note 4)
— 13.9 64.7 13.9 — —
(Continued on next slide)
 11-9

Earnings Persistence
Recasting Earnings and Earnings Components
Campbell Soup Company
Recast Income Statements ($ mil.)
Item Year 11 Year 10 Year 9 Year 8 Year 7 Year 6
Gain on sale of businesses in (Yr 8) and sub. in Yr 7 — — — 3.1 9.7 —
Loss on sale of exercise equipment subsidiary, net of tax — — — — (1.7) —
LIFO liquidation gain (see Note 1 below) — — — 1.7 2.8 1.4
Income before cumulative effect of accounting change$ 401.5 $ 4.4 $ 13.1 $ 241.6 $ 247.3 $ 223.2
153A Cumulative effect of accounting change for income taxes — — — 32.5 — —
28 Net income as reported $ 401.5 $ 4.4 $ 13.1 $ 274.1 $ 247.3 $ 223.2
14 (Note 1) Cost of products sold $ 4,095.5 $ 4,258.2 $ 4,001.6 $ 3,392.8 $ 3,180.5 $ 3,082.8
144 Less: Repair and maintenance expenses (173.9) (180.6) (173.9) (155.6) (148.8) (144.0)
162A Less: Depreciation(a) (194.5) (184.1) (175.9) (162.0) (139.0) (120.0)
153A Plus: LIFO liquidation gain(b) — — — 2.6 5.1 2.6
$ 3,727.1 $ 3,893.5 $ 3,651.8 $ 3,077.8 $ 2,897.8 $ 2,821.4
15 (Note 2) Marketing and selling expenses $ 956.2 $ 980.5 $ 818.8 $ 733.3 $ 626.2 $ 544.4
145 Less: Advertising (195.4) (20.4) (212.9) (219.1) (203.5) (181.4)
$ 760.8 $ 960.1 $ 605.9 $ 514.2 $ 422.7 $ 363.0
21 (Note 3) Other expenses (income) $ 26.2 $ 14.7 $ 32.4 $ (3.2) $ (9.5) $ 5.5
102 Less: Stock price–related incentive programs (15.4) 0.1 (17.4) 2.7 — (8.5)
103 Less: Amortization of intangible and other assets (14.1) (16.8) (16.4) (8.9) (5.6) (6.0)
Less: Gain on sale of businesses (Yr 8) and sub. (Yr 7) — — — 4.7 14.7 —
104 Other, net $ (3.3) $ (2.0) $ (1.4) $ (4.7) $ (0.4) $ (9.0)
(Note 4) Tax effect of divest, restruc., & unusual charges — $ 115.3(c) $ 116.6(d) $ 13.9 — —
136 Nondeductible divestitures, restructuring, and unusual charges
— (101.4)(e) (51.9)(f) — — —
— $ 13.9 $ 64.7 $ 13.9 — —

*Statutory federal tax rate is 34% in Year 8 through Year 11, 45% in Year 7, and 46% in Year 6.
†
This amount is not disclosed for Year 6.
(a)
We assume most depreciation is included in cost of products sold.
(b)
LIFO liquidation gain before tax. For example, for Year 8 this is $2.58 million, computed as $1.7/(1 - 0.34).
(c)
$339.1 (22) x 0.34 = $115.3.
(d)
$343.0 (22) x 0.34 = $116.6
(e)
$179.4 (26) x 0.565 (136) = $101.4.
(f)
$106.5 (26) x 0.487 (136) = $51.9.
 11-10

Earnings Persistence
Adjusting Earnings and Earnings Components
• “Adjusting” aims to assign earnings components
to the periods in which they best belong.
• Uses data from recast income statements and
other available information.
 11-11

Earnings Persistence
Adjusting Earnings and Earnings Components
• Specific (Typical) Adjusting Procedures
– Assign extraordinary and unusual items (net of tax) to applicable
years
– Tax benefit of operating loss carryforwards normally moved to
the loss year
– Costs or benefits from lawsuit settlements moved to relevant
prior years
– Gains and losses from disposals of discontinued operations can
relate to one or more prior years.
– Changes in accounting principles or estimates yield adjustments
to all years under analysis to a comparable basis—redistribute
“cumulative effect” to the relevant prior years
– Normally include items that increase or decrease equity
 11-12

Earnings Persistence
Adjusting Earnings and Earnings Components
• Specific (Typical) Adjusting Procedures
– If a component should be excluded from the period it is
reported:
• Shift it (net of tax) to the operating results of one or more prior
periods or
• Spread (average) it over earnings for the period under analysis.
– Spread the component over prior periods’ earnings only
when it cannot be identified with a specific period.
– While spreading helps in determining earning power, it is
not helpful in determining earnings trends.
– Moving gains/ losses to other periods does not remedy the
misstatements of prior years’ results.
 11-13

Earnings Persistence
 11-14

Earnings Persistence
Determinants of Earnings Persistence

• Earnings persistence determined by many factors

including:
– Earnings trends
– Variability
– Earnings Management
– Management Incentives

• Note: assess earnings persistence

over both the business cycle and the long run.
 11-15

Earnings Persistence
Determinants of Earnings Persistence

• Earnings trends can be assessed by:

– Statistical methods
– Trend statements
• Uses earnings numbers taken from the recasting
and adjusting procedures
 11-16

Earnings Persistence
Determinants of Earnings Persistence

• Earnings management
– Changes in accounting methods or assumptions
– Offsetting extraordinary or unusual gains and losses
– Big baths
– Write-downs
– Timing revenue and
expense recognition
 11-17

Earnings Persistence

Determinants of Earnings Persistence

• Management incentives affecting persistence
include:
– Personal objectives and interests
– Companies in distress
– Prosperous companies—preserving hard-earned
reputations
– Compensation plans
– Accounting-based incentives and constraints
– Analysts’ targets
 11-18

Earnings Persistence
Persistent and Transitory Items in Earnings
• Recasting and adjusting earnings for equity valuation
rely on separating stable, persistent earnings
components from random, transitory components.
– Assessing persistence is important in determining earning
power.
– Earnings forecasting also relies on persistence.
• A crucial part is to assess the persistence of the gain
and loss components of earnings.
 11-19

Earnings Persistence
Analyzing and Interpreting Transitory Items
• Purpose of analyzing and interpreting extraordinary
items:
– Determine whether an item is transitory.
• Assessing whether an item is unusual, nonoperating, or
nonrecurring.
– Determine adjustments that are necessary given
assessment of persistence.
 11-20

Earnings Persistence
Analyzing and Interpreting Transitory Items
• Determining persistence
(transitory nature) of items:
– Nonrecurring operating gains and losses
• Usually included in current operating income
– Nonrecurring non-operating gains and losses
• Omitted from operating earnings of a single year
• Part of the long-term performance of a company
 11-21

Earnings Persistence
Analyzing and Interpreting Transitory Items
• Adjustments to Extraordinary Items Reflecting
Persistence:
– Effects of transitory items on company resources.
• Effects of recorded transitory items and the likelihood of future
events causing transitory items.
– Effect of transitory items on evaluation of management.
 11-22

Earnings Based Equity Valuation

Relation between Stock Prices and Accounting Data

• Equity value (Vt)

• Book value (BVt)
• Residual Income, RIt = (NIt – k * BVt-1)
• Cost of equity capital (k)

Key Question: Does the potential manipulation of

accounting data influence the accuracy of accounting-
based estimates, or forecasts, of company value?
 11-23

Earnings Based Equity Valuation

Fundamental Valuation Multiples

• Price-to-Book (PB) Ratio

Market Value of Equity
Book Value of Equity
 11-24

Earnings Based Equity Valuation

Fundamental Valuation Multiples
• Price-to-Book (PB) expressed in accounting data
Vt   ROCE t 1 k     ROCE t  2 k  BVt 1    ROCE t  3 k  BVt  2 
1       ...
BVt  1  k    1  k  2
BVt    1  k  3
BVt 

Note:
 ROCE and growth in book value increase  PB increases
 Cost (risk) of equity capital increases  PB decreases
 Present value of future abnormal earnings is positive (negative)
 PB is greater (less) than 1.0
 11-25

Earnings Based Equity Valuation

Fundamental Valuation Multiples
• Price-to-Earnings (PE) Ratio

Market Value of Equity

Net Income
 11-26

Earnings Based Equity Valuation

Fundamental Valuation Multiples
• PE ratio can be written as a function of short-term (STG) and
long-term growth (LTG) of earning per share (eps) as follows:

Where k is the cost of equity capital, STG (LTG) is the expected short-
term (long-term) % change in eps relative to expected “normal” growth
(STG>LTG and LTG>k)
Note:
The PE ratio is inversely related to k
The PE ratio is positively related to the expected growth in eps
relative to normal growth.
 11-27

Earnings Based Equity Valuation

Fundamental Valuation Multiples
• PEG ratio
• If LTG=0 (long-term growth in eps relative to “normal”
growth is expected to remain constant)

This yields the popular PEG ratio.

Example: If PE=20 and k=10%,
proponents of this screening device
recommend stock purchase (sale) if
the expected eps growth is greater
(less) than 20%.
 11-28

Earnings Based Equity Valuation

Illustration of Earnings-Based Valuation

Christy
ChristyCo.
Co.book
bookvalue
valueofofequity
equityat
atJanuary
January1,1,Year
Year1,
1,is
is$50,000
$50,000
Christy
Christyhas
hasaa15%
15%cost
costofofequity
equitycapital
capital(k)
(k)
Forecasts
Forecastsof
ofChristy’s
Christy’saccounting
accountingdata
datafollow:
follow:

Year
Year11 Year
Year22 Year
Year33 Year
Year44 Year
Year55
Sales
Sales $$100,000
100,000 $$113,000
113,000 $$127,690
127,690 $144,290
$ 144,290 $144,290
$144,290
Operating expenses
Operating expenses 77,500
77,500 90,000
90,000 103,500
103,500 118,000
118,000 119,040
119,040
Depreciation
Depreciation 10,000
10,000 11,300
11,300 12,770
12,770 14,430
14,430 14,430
14,430
Net income
Net income $ 12,500 $ 11,700 $ 11,420 $
$ 12,500 $ 11,700 $ 11,420 $ 11,860 11,860 $$ 10,820
10,820
Dividends
Dividends 6,000
6,000 4,355
4,355 3,120
3,120 11,860
11,860 10,820
10,820

Year
Year 66 and
and beyond
beyond == Both
Both accounting
accounting data
data and
and dividends
dividends
approximate
approximateYear
Year55levels
levels
 11-29

Earnings Based Equity Valuation

Illustration of Earnings-Based Valuation

Christy’s
Christy’s forecasted
forecasted book
book value
value at
at January
January 1,
1, Year
Year 11 isis
$58,594—computed
$58,594—computedas: as:

This
This implies
implies Christy
Christy stock
stock should
should sell
sell at
at aa PB
PB ratio
ratio of
of 1.17
1.17
($58,594/$50,000)
($58,594/$50,000)at atJanuary
January1,1,Year
Year 11
 11-30

Earnings Based Equity Valuation

Illustration of Earnings-Based Valuation
• Three additional observations:
– Expected ROCE = 15% (Christy’s cost of capital) for Year 5 and
beyond. Since ROCE equals the cost of capital for Year 5 and
beyond, these years’ results do not change the value of Christy
(i.e. abnormal earnings equal zero for those years). Anticipated
effects of competition are implicit in future profitability estimates.
– Since PE ratios are based on both current and future earnings, a
PE ratio for Christy as of January 1, Year 1, cannot be calculated
since prior years’ data are unavailable. PE ratio at January 1,
Year 2 is computed as:
 11-31

Earnings Based Equity Valuation

Illustration of Earnings-Based Valuation

– Valuation estimates assume dividend payments occur at the end

of each year. A more realistic assumption is that, on average,
these cash outflows occur midway through the year. To adjust
valuation estimates for mid-year discounting, multiply the PV of
future abnormal earnings by (1 + k/2). For Christy Company the
adjusted valuation estimate equals $59,239. This is computed as
$50,000 + (1 + [.15/2]) x $8,594.
 11-32

Earning Power and Forecasting for Valuation

Earning Power
• Earning power is the earnings level expected to persist
into the foreseeable future
– Accounting-based valuation models capitalize earning power
– Many financial analyses directed at determining earning power
• Measurement of Earning Power reflects:
– Earnings and all its components
– Stability and persistence of earnings
and its components
– Sustainable trends in earnings and its
components
 11-33

Earning Power and Forecasting for Valuation

Earning Power
• Factors in selecting a time horizon for measuring earning
power:
– One-year is often too short to reliably measure earning power
– Many investing and financing activities are long term
– Better to measure earning power by using average (or
cumulative) earnings over several years
– An extended period is less subject to distortions, irregularities,
and other transitory effects
– Preferred time horizon in measuring earning
power is typically 4 to 7 years
 11-34

Earning Power and Forecasting for Valuation

Earning Power
• Adjusting Earnings per Share
– Earning power is measured using all earnings components.
– The issue is to what year we assign these items when computing
earning power.

Our earnings analysis might be limited to a short time

horizon. We adjust short time series of earnings for
items that better relate to other periods. If this is done
on a per share basis, every item must be adjusted for
its tax effect using the company’s effective tax rate
unless the applicable tax rate is specified. All items
must also be divided by the number of shares used in
computing EPS.
 11-35

Earning Power and Forecasting for

Valuation
 11-36

Earning Power and Forecasting for Valuation

Earnings Forecasting
• Done by analyzing earnings components and considering all
available information, both quantitative and qualitative.
– Forecasting benefits from disaggregation.
– Disaggregation involves using data by product lines or segments
• Especially useful when segments differ by risk, profitability, or growth.
– Difference between forecasting and extrapolation.

Divisional earnings for TechCom, Inc., reveal how different divisional

performance can be masked by aggregate results:
 11-37

Earning Power and Forecasting for Valuation

Earnings Forecasting
• Elements Impacting Earnings Forecasts
– Current and past evidence
– Forecast’s reasonableness.
– Continuity and momentum of company performance
– Industry prospects
– Company's financial condition
– Management
• Management quality—resourcefulness
• Asset management—operating skills
– Economic and competitive factors
– Key Indicators such as capital expenditures, order backlogs,
and demand trends
 11-38

Earning Power and Forecasting for Valuation

Interim Reports for Monitoring and Revising Earnings Estimates

• Limitations in interim reporting related to difficulties in

assigning earnings components to periods of under one
year in length:
– Period-end accounting adjustments
– Seasonality in business activities
– Integral reporting method
– SEC interim reporting requirements
– Analysis implications of interim Reports
 11-39

Earning Power and Forecasting for Valuation

Interim Reports for Monitoring and Revising Earnings Estimates

• Available Interim Reports
– Quarterly reports (Form 10-Q)
– Reports on current developments (Form 8-K)
– Disclosure of separate fourth-quarter results
– Details of year-end adjustments
• Interim reports filed with the SEC such as:
– Comparative interim and year-to-date income statement
– Comparative balance sheets
– Year‑to‑date statement of cash flows
– Pro forma information on business combinations
– Disclosure of accounting changes
– Management’s narrative analysis of operating results
– Reports of a change in auditor